THE FREE MARKET SYSTEM

The free market is a system where the main economic decisions what, how and for whom to produce, are made by firms and households with a minimum of government interference.



Many economists believe that Adam Smith wrote the first, and best, explanation of the free market system in 1776. So important are the thoughts and writing of Adam Smith that he is pictured on the back of every £20 note issued by the Bank of England. In his book ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, Smith writes,

‘It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages’.

In a completely free market economy people are free to produce whatever they want, but if they choose to do nothing they quickly starve. It might be tempting to think that if you work hard that you will prosper and whilst it is true that hard work helps, alas this is not sufficient; the people who clean schools work hard but are on a small wage!

People are supposed to be welfare maximizers; they buy things that they both need and want, and rational people think carefully how to spend their money. So in a free market system people increase their chances of being rich by producing things that other people wish to buy. Although selling things that people need and want is a necessary first step, there are many things that are so easy and abundant to supply that there is no money to be made making them. Air is a free good and it is so abundant in supply there would be no profit standing on a street corner trying to sell it to passers-by, despite the fact they all want and need it. In a free market, producing things that are wanted, but short in supply is the route to wealth . Thus there are two factors to take into account, the production of goods and services - which we call supply, and the desires of people who want, and are able to pay for, these goods and services - which is called demand.

Things that people want and need command higher prices than those things that people do not want. When things are scarce there is more demand than supply and prices are high. When prices are rising the free market sends a signal, and this signal is saying produce more of these scarce goods. Self-interested persons see these signals and observe that there is profit to be made by supplying more of them. As more and more people see the price signal and start providing that good or service, the supply rises. As supply increases the product becomes less scarce and the price begins to fall and if supply rises too much the price falls so low that producers cannot make a profit, and they see the signal and stop making the good or service - or else they become bankrupt. This is how the free market system works and Adam Smith described it more eloquently,

‘As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (Wealth of Nations. VI, ii. P.456).

In free market systems, the questions how, what and for whom may be decided by firms and households, but this does not mean there is no government. Free market systems are also capitalist systems, which means that capital is privately owned. Private ownership means that property-rights have to be enforced so laws, courts and police forces are needed, and in a world of nation-states so are armed forces.

Advantages of free market systems
1. In free markets, prices act like traffic signals so that when retail prices rise, other things being equal, the profits of firms rise indicating that more supply is required, and in turn this raises the derived demand for the factors of production and their prices too.

2. No expensive state planning organization is required because planning is left to the ‘invisible hand’ of the market.

3. The profit motive means firms sell products that people want and these firms try to produce products at lower cost, and or, better quality than their competitors.

4. The free market produces a greater range of products and therefore greater consumer choice than planned economies.

5. The factors of production are put to their most profitable use and the market guides people with a natural aptitude for something into professions and occupations that they are best suited for.

6. Despite the disparity of incomes in a free market system, eventually even the poorest enjoy the innovative products created because market systems encourage and reward new inventions and drive down costs.
Even if monopolies arise in the short run, the high profits in that industry encourage innovation so that in the long run the monopoly power is lost.

Prices act as signals directing resources into their best use, provide incentives for hard work and innovation, and act as a rationing system for scarce resources. Believers in free markets argue that they are allocatively efficient and productively efficient.

Disadvantages of free markets
1. Inequalities of income and wealth create uncomfortable social relations and in the worst cases can lead to violence and revolution.

2. Public goods such as streetlights, and merit goods such as education, are under-provided and under-consumed.

3. Demerit goods such as cigarettes and alcohol are over-provided and over-consumed.

4. Advertising and marketing create wants that wouldn’t otherwise exist and this wastes scarce resources.

5. Monopolies arise which exploit consumers by under-supplying the market and over-charging.

6. Negative effects (negative externalities) are caused when prices do not accurately reflect social costs; for example, the costs of pollution from power stations are not included in the price of electricity.

CENTRALLY PLANNED (COMMAND ECONOMIES)

A centrally planned economy is one where the main economic decisions; what, how and for whom to produce are made by a central authority.

In a pure centrally planned economy: the state owns or controls all the factors of production, it decides what, how and for whom to produce, and all workers are employed by the state. Classic examples of central planning were the Union of Soviet Socialist Republics (USSR) and all of the eastern bloc countries that fell under Russia’s control after 1917 and before 1990 when the system collapsed. The People’s Republic of China, Cuba, Vietnam and North Korea are all present day examples of centrally planned economies, but all of these, with the exception of North Korea, have allowed a greater degree of free market activity in recent years. What all of these countries have in common is that they are or were socialist. Socialism is a political philosophy whereby the commanding heights of the economy are owned and controlled by the state and there is very little if any private property. It is therefore tempting to equate central planning with socialism or communism but is also true that some capitalist countries, where the means of production are privately owned, such as Nazi Germany and the UK, were highly centralized during the Second World War. Even the United States had a system of price control during the war.

Planned economies require input-output analysis, which involves dividing the economy up into sectors. Each sector is a user of inputs and acquires them from a supplier from another sector. This technique allows the inputs and outputs to be matched with the total resources available in the economy. Advocates of input-output analysis point out that large corporations such as Ford or Toyota plan their production, and because their sales are larger than the gross domestic product of many countries, there is no reason why a whole economy cannot be planned in the same way.

It is important to understand the difference between a theoretical planned economy, where all the conditions in the first paragraph above are completely true, and the actuality of command economies such as the former USSR. What the rhetoric promised and reality delivered was very different. The hopes of Marxist/Leninism and the remittances of Stalinism didn’t quite match. Despite what you might currently believe about planned economies, particularly the socialist/communist ones, bear in mind that economics is a social science, and it requires you to keep an open mind and asks you to look at what is good about these systems, not just take a dogmatic approach that communism equals bad. You can make a judgment about central planning later, when you have examined the arguments properly.

Advantages of planned economies
1. Recessions, and depressions, particularly the Great Depression of the 1930s, highlight a central failing of market economies - that they move in cycles, unemployment arises and persists and the lives of millions are blighted. Planned economies, on the other hand, can ensure that everyone has a job.

2.Because the state owns and controls all business, this means private monopolies do not exist and (theoretically) the exploitation of consumers through high prices and under-supply is avoided.

3.Decisions that benefit the mass of the population can be made. For example the production of merit goods such as schools and health-care can be provided for everyone, not just for those with the means to pay.

4. Persuasive advertising and marketing is not required, and because they are costly and create needless wants, resources are put to better uses.

5. Land, labour and capital can be focused on producing capital goods and away from consumer goods – resulting in higher growth in the long run.

Disadvantages of planned economies
1. Labour is directed into jobs and professions and this means the most suitably skilled people do not necessarily end up in occupations that they are best qualified for. Sometimes workers may be doing jobs that are not necessary or less efficiently than a machine might, i.e. hidden unemployment will exist.

2. There is a lack of incentives. Hard work and innovation is under-rewarded so that new inventions are slow to arrive and there may be a lack of enthusiasm for work.

3. Planning is expensive. A centrally planned economy needs a team of planners and the more advanced the economy is the more planners it requires, and these planners do not get everything right, hence;

4. Demand for goods and services are hard to anticipate because prices are regulated and they do not perform the signaling function that they do in free markets. This leads to over or under-production. For example, it is difficult to accurately forecast the number of coffins that may be needed in any year. In a particularly hard winter the supply of coffins might be insufficient.

5. Lack of choice. In a planned economy the range of goods and services is likely to be narrow. Fashions are staid and the joy of wearing trendy clothes or driving a particular brand of car is lost.

6. A lack of political freedom. Milton Friedman and Friedrich von Hayek, to name just two, have argued that planned economies equate to a lack of freedom. Not being able to choose where to work, to live or even to disagree with the central planners is an inevitable consequence of command economies.

TRADITIONAL (SUBSISTANCE) ECONOMIES

A traditional economy is where the main economic question; what, how and where to produce, are decided by tradition, i.e. things are done they have always been done. There is little division of labour and as a result not much surplus production and therefore very little trade.

MIXED ECONOMIES

Whether or not a country is centrally planned or a free market economy, the economic question, what, how and for whom to produce has to be answered. In the great majority of countries today, economic choices are made partly by the state and partly by the free market. In reality, as opposed to the theoretical model of perfectly competitive free markets, countries are mixed economies with some goods being allocated and produced by the state (the public sector) and some through the free market (the private sector). Hong Kong has an economy that is mostly left to the free market whereas Cuba has a very small free market sector and most of the economic decisions are made by the government.